Debt Settlement Vs. Bankruptcy: Pros and Cons of Each Option
7 MIN READ
Published August 22, 2023 | Updated December 11, 2023
Debt settlement and bankruptcy can both be part of a debt management plan to help you get back on track and find a way out of overwhelming debt. Debt settlement involves negotiating with your lenders to reduce the amount you owe. Bankruptcy can provide you with a fresh start by reorganizing or discharging your debts.
Deciding which strategy is the best requires you to take a closer look at the differences between debt settlement vs. bankruptcy and how each of these options works.
Definition of Debt Settlement
Debt settlement is a process in which you or a debt relief company attempts to get lenders to accept a portion of your debt as payment in full. If you have significant debt, have missed payments, and are unable to pay off your balance in full, this may be a good option to consider.
Definition of Bankruptcy
Bankruptcy is a legal process that allows you to restructure or discharge your debts. The two main types of bankruptcy to know about are Chapter 7 and Chapter 13.
Chapter 7 bankruptcy can wipe off debts fairly quickly. But you’ll need to qualify for it based on your income. Additionally, you’ll need to liquidate any non-exempt property.
With Chapter 13 bankruptcy, you’ll be allowed to retain your property, but you’ll need to stick to a repayment plan of up to 5 years. During this time, you can catch up on your payments, and once you’ve made monthly payments for the specified duration, the court will discharge the remaining debts.
Debt Settlement Vs. Bankruptcy: Which One to Opt For
Debt settlement and bankruptcy work in very different ways. To determine the right option, you’ll need to consider the amount of debt you have, your assets, and your income. Additionally, compare the pros and cons of each option so you can make an informed decision.
Pros of Debt Settlement
- You may be able to settle credit card debts and other unsecured debts on your own if you are persistent and organized.
- Debt settlement may help you avoid bankruptcy.
- It allows you to save up to 50% on enrolled debts before fees since you’ll only be paying a portion of your original debt.
- You’ll be able to get out of debt faster. With only a portion of your debt to pay, you may be able to save that amount faster and pay off your debts.
Cons of Debt Settlement
- Not all debt collectors will be willing to accept a settlement. In that case, you’ll still be liable to pay those debts.
- Your credit score will take a hit. You’ll need to stop making payments to your lenders to save for a settlement. This will lower your credit score.
- If your debt is substantial, the lender may sue you. If you lose the case in court, it may result in wage garnishment.
- You’ll need to pay taxes on any forgiven amount.
Pros of Bankruptcy
- Bankruptcy can wipe off unsecured debts such as credit card debts, personal loans, medical debts, and more.
- You’ll get a clean slate and can rebuild your finances from scratch after bankruptcy.
- Once you file for bankruptcy, all collection efforts, such as wage garnishments, repossessions, and foreclosures, will stop.
- Bankruptcy is also fairly quick. In the case of Chapter 7, the process usually takes six months to complete.
- You won’t have to pay taxes on the forgiven debt.
Cons of Bankruptcy
- Bankruptcy can be expensive, especially due to substantial attorney fees.
- It stays on your credit report for up to 10 years.
- You’ll have to pass the means test to be eligible to file bankruptcy.
- You may not be able to shield non-exempt property.
- You’ll need to stick to the court-ordered payment plan to repay your debts.
- It makes it challenging to borrow money again.
- You’ll still need to pay alimony, tax debt, child support, and student loans.
Comparison of the Two Options
Beyond debt settlement vs. bankruptcy pros and cons, you’ll also need to compare how the two options work and the legal implications of each so you can choose the right option.
Legal Implications of Debt Settlement
Debt settlement may not always allow you to escape unscathed from your debts. If you owe a substantial amount, your lender may choose to sue you in court even if you are negotiating for a settlement. Losing the case may lead to account levies and wage garnishment.
Additionally, you should be aware of the tax implications of debt settlement. If your lender accepts the settlement, any amount that they forgive is considered taxable income. That means you’ll need to pay taxes on it to the IRS.
Legal Implications of Bankruptcy
Bankruptcy is a complex process, and it’s best to work with a bankruptcy attorney to ensure that the process goes smoothly. You’ll need to meet a few requirements to be eligible to file for bankruptcy. For example, you’ll need to complete credit counseling, which is a requirement for filing.
You’ll likely lose your assets, depending on the type of bankruptcy you are filing for and the nature of the assets. The assets will be sold to repay your creditors. The bankruptcy information will stay on your credit report for ten years. This means that lenders will be less likely to work with you in the future.
Process of Debt Settlement
The process of settling your debts is quite straightforward, whether you decide to do it yourself or through a debt settlement company. Working with a professional, however, can make the process easier and stress-free for you.
Here’s what to expect from the process:
- When negotiating credit card debt on your own, you’ll need to communicate with your lenders to explain your circumstances.
- Decide on a settlement amount and send the offer to your lenders in writing. The negotiation process may take time, but you’ll need to continue making payments to your lenders until you reach an agreement.
- If you choose to work with a debt relief company, you’ll be required to stop making payments to your lenders.
- The debt settlement company will set up a separate bank account, and you can make deposits in that account each month to save towards a lump sum settlement.
- Once you have saved enough money, the settlement company will use those funds to pay your lenders.
Process of Bankruptcy
It’s best to get legal advice from a bankruptcy lawyer to help you navigate the process of filing. Take the time to learn more about how this process works. Here are a few basic steps you’ll need to follow to get started:
- Collect all your financial records. You’ll need to provide the court with a better understanding of your financial situation, so make a list of your income sources, expenses, assets, and debts.
- You’ll only be able to file once you’ve completed the mandatory bankruptcy counseling.
- The next step is to file your petition. This is a serious and complex process that requires you to have an understanding of federal and state bankruptcy laws. Seek help from a lawyer who can help you file with the right forms and documents.
- Once your petition is accepted, you’ll need to attend a meeting with your creditors that a trustee will set up.
- The next steps will depend on the type of bankruptcy you are filing for. With Chapter 13, you’ll have to make court-ordered payments to your creditors. Chapter 7 involves the liquidation of your assets to pay off your lenders.
Options Available with Each
When comparing debt settlement vs. bankruptcy, debt settlement is a simpler process. This means you do have the option to negotiate the settlement yourself or hire a professional to negotiate on your behalf. If you are organized, persistent, and confident in your ability to negotiate, DIY debt settlement may be an option to consider.
Bankruptcy is complex and has lasting consequences, so the DIY route is not recommended. Your best option is to hire a law firm specializing in bankruptcy.
Choosing the Right Option
Choosing between options like debt settlement and validation or bankruptcy comes down to your individual circumstances. Bankruptcy is usually the last resort when no other debt-relief options will work for you. That said, you should consider the alternatives available to you and think about how each option will impact your credit score before you make a decision.
If you think neither debt settlement nor bankruptcy is the right option, there are several other alternatives available to choose from:
- Debt Management: You can enroll in a debt management program to get the benefit of lower interest rates, waived fees, and other benefits. You’ll make a single payment each month toward all your debts. You don’t need to get a new credit card or a new loan with a debt management plan, so your current credit score doesn’t matter.
- Credit Counseling: Credit counselors can give you advice on your budget, debt repayment, and money management. If you’re not sure how to start paying off your debts, nonprofit credit counseling agencies are a good resource for education.
- Debt Consolidation: If you have a good credit score, you may be able to qualify for a debt consolidation loan at a lower interest rate. You can roll all your high-interest debts into one to save money on interest and to make your payment schedule simple and manageable.
Understanding the Consequences of Debt Settlement and Bankruptcy
We’ve already talked about the legal consequences of debt settlement vs. bankruptcy. But it’s also important to know how each of these options will affect your credit score.
Regardless of the type of bankruptcy you file for, your credit score will suffer greatly. Additionally, Chapter 13 will stay on your credit report for seven years, while Chapter 7 will stay on your credit for ten years.
Debt settlement also negatively impacts your credit score. When you settle an account, it means you didn’t pay your debts in full. The drop is significant, but it isn’t as much as bankruptcy. Settled accounts may remain on your credit report for seven years, and it may impact your ability to get a new loan or the interest rate you’ll qualify for.
Rebuilding Credit After Debt Settlement or Bankruptcy
Debt settlement and bankruptcy may have a negative impact on your credit report, but it’s possible to recover from it. With good credit and money management habits, you can rebuild your credit.
Rebuilding Credit After Debt Settlement
Here are some effective ways to start rebuilding your credit after debt settlement:
- Monitor your credit report regularly.
- Dispute any errors you spot.
- Pay your bills in full on time each month.
- Keep your credit utilization ratio low. Do not use more than 30% of your credit card limit.
- Get a secured credit card. You’ll need to provide a deposit to get the card, but it’s easier to get even if you have bad credit. Use the new card wisely and make payments on time to establish a good credit history. After a while, you may be eligible for unsecured credit cards.
- Avoid taking out new loans unless it’s an emergency.
Rebuilding Credit After Bankruptcy
The effect of bankruptcy will diminish over time. If you use credit responsibly, your credit score will improve gradually. The tips listed above also apply to bankruptcy. Here are a few additional tips to follow:
- Set a budget to account for all your bills.
- Do not apply for credit too often. Hard credit inquiries will lower your credit score further.
- Automate all your bills so you can avoid missed payments or late payments.
- Invest time in strengthening your financial literacy. If required, work with a personal finance professional to learn more about managing your finances better.
Final Thoughts When Comparing Bankruptcy and Debt Settlement
There are a number of debt relief options available for borrowers to help them regain control of their finances and become debt-free. When choosing between debt settlement vs. bankruptcy, or options like bankruptcy and debt consolidation, it’s important to understand the differences between the two and how they may impact your future. If you are still undecided, speak to a credit counselor or a professional to see which option may be best suited for your circumstances.
If you have over $10k in unsecured debts, TurboDebt can help you identify the right debt relief option for your needs. Get in touch with us for a free consultation today.